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I’m often asked what I think about the “4% rule” for spending in retirement. According to this rule of thumb, an individual who is planning on a 30-year investment horizon and is holding a broadly diversified and balanced investment portfolio of stocks and bonds, can—with a reasonably low probability of running out of money over 30 years—spend an amount equal to roughly 4% of their total retirement portfolio in the first year, and then adjust that withdrawal every year thereafter for inflation.

One of the easiest ways to see where this “rule” comes from is the chart below.

Note: Using historical performance data, the chart shows what dollar amount could have been withdrawn from a portfolio (rebalanced monthly to a fixed asset allocation) to exactly exhaust that portfolio over 30 years.

Assuming you had started spending in any month from January 1926 to July 1979, the chart shows how much you could have spent historically following an inflation-adjusted spending rule, so that you would have exactly exhausted your portfolio after 30 years. The data show that if you wanted to steer clear of historical scenarios where you spent more than the portfolio could produce over 30 years, you’d have had to start with an amount equal to 4% or less of the starting balance. Spending 4% didn’t lead to success 100% of the time (all three lines dip below 4% in the late 1960s and early 1970s), but was close to the lower limit in the data. Also note that since this is based on costless index returns, spending here has to include whatever fees you paid to make these investments. So there you go: “4% adjusted for inflation” is a plausible spending guideline based on the history and this assumed spending pattern.

Now, when economists hear about this “4% rule” for spending in retirement, they tend to cringe. (At least one well-known one has written an article explaining some reasons why.) One of the biggest issues they point out is, as the chart shows, that the “4% rule” in most cases tends to leave a lot of money unspent (at least over the 30-year horizon), and is hence potentially inefficient. Perhaps even more critically, the rule doesn’t allow, or really even envision, that people would revisit their spending rate going forward from the starting point. For example, if you start spending an amount equal to 4% of your portfolio, and then the market ends up going up much more than inflation, how come you can’t increase your spending by more than inflation? Presumably your horizon isn’t longer this year than it was last year, and now, 4% of the portfolio would be a higher number than last year’s 4% plus inflation. Beyond this, there is of course the “what-happens-if-I-live-to-year-31-risk” that the rule ignores entirely.

All valid criticisms. And there are alternative spending rules (based on academic work that has existed for decades) that could potentially be better—or at least more complete—solutions in a variety of ways. However, I would argue that most of these alternative, model-based approaches are only obviously superior if a retiree fully understands and accepts the models and framework used to derive the optimality results. The models and embedded behavioral assumptions are complex, and, while intuitive to economists, may not “feel right” to people in the real world.

As an example, consider an individual with no desire to leave an estate, whose required absolute minimum needed spending will be completely funded by Social Security, and who is not facing any uninsured risks. (Just go with it for a minute). We can use a “standard economics” framework to think about optimally spending whatever assets they have accumulated. But first we need to make still more assumptions about important issues—specifically: constant relative risk aversion utility with intertemporal elasticity of consumption equal to one-third, a pure discount rate of 1% per year, a real (and, to keep things simple) riskless rate of return of 2.5%, and mortality expectations in line with a 50/50 average male/female (unisex) version of the RP2000 mortality tables. Assuming one even understands what they mean in the first place, these are each debatable assumptions.

Anyway, in that theoretical world, for an individual attempting to optimize spending, you’d get the pattern in the chart below. Spending starts out about 15% higher than the 4% rule would prescribe, but after age 85 (assuming one lives that long), spending is lower than the rule would have prescribed. The pattern reflects that in the economic framework, people are looking forward as they are optimizing, and trading off the higher likelihood of not being around against the lower satisfaction they will get from spending less if they are around. The 4% rule is, in contrast, designed to target a fixed, minimum level of spending over a specific period of time.

I’ve shown this kind of result to a few people and gotten different reactions. A big one is that, on its face, the assumption that a retiree faces no uninsured risks is just silly. Many are also uncomfortable with the notion that if they make it to 90, they are going to be spending 30% less than at age 70. What do you think?

Bottom line, the 4% “rule of thumb” is just that—a rule of thumb. It’s based on an understandable, if not particularly complex set of assumptions about behavior and historical data on the markets. And as a baseline guide for setting individuals’ spending expectations at retirement, it’s in the ballpark, generating an initial spending recommendation that is arguably close to what comes out of a more complicated analysis.

While it’s not perfect, and it’s easy to be a critic, it’s tough to ask for a lot more than that in as simple a package.

Notes:

• All investments are subject to risk. Investments in bond funds are subject to interest rate, credit, and inflation risk. Diversification does not ensure a profit or protect against a loss in a declining market.

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John Ameriks

John Ameriks oversees the Active Equity Group within Vanguard Equity Investment Group, which manages active quantitative equity fund assets. He is one of Vanguard's thought leaders on retirement issues and has conducted studies on a wide range of personal financial decisions, including saving, portfolio allocation, and retirement income strategies. John came to Vanguard in 2003 from the TIAA-CREF Institute, the research and education arm of TIAA-CREF. He graduated from Stanford University with an A.B. and earned a Ph.D. in economics from Columbia University.

Comments

Anonymous | August 28, 2010 12:01 pm

The simple model I have used for about twenty years uses the 4% rule (it was the Harvard Endowment stricture for colleges, assuming they want their money to last ‘forever’), with a terminal date based upon my wife’s life expectancy. In general, the final balance has been significantly positive, with just a few months around zero balance at ‘death’.
With the S&P showing a negative return currently (YTD) and over the last decade, and the recent total return on bonds way inflated by the crash in rates, it takes a brave man to project much more than break-even, in real terms, going forward.
For now I am using a base spending limit, including taxes, of, implicitly, 3%. If this seems pessimistic, it is probably because expense inflation, in my model, is set at the higher of 4.5% or 10YT – 10YTips + 3%.
Guessing our way into the Chinese century.

Anonymous | August 27, 2010 1:37 pm

I read your 2001 article “Making Retirement Income Last a Lifetime” in which you examined a 4.5% withdrawal rate based on historical data and Monte Carlo simulations, then mixed in annuitization of 25% and 50% of the portofolio. For a 65-year-old individual, the annual annuity payments amounted to about 9% of the amount annuitized, and always seemed to improve the chances that the portofolio would not be exhausted, expecially with longer retirement periods. It would be interesting to see how current annuity payouts based on todays lower interest rates would affect this observation.

Anonymous | August 27, 2010 11:31 am

Anonymous | August 27, 2010 8:18 am

Why do so many people want to be told how to manage their retirement funds? If they managed their pre-retirement income without help, they should not need any help after retirement. On the other hand, if they could not manage their pre-retirement income, then I suspect the are beyond help.

As for leaving the principle to heirs, that is fine for sizable fortunes but not at all practical for working class or even most professional class people. We raise our kids to make their own way, not to expect mommy and daddy or the government to take care of them all their lives.

Anonymous | August 26, 2010 11:46 pm

This seems to fit with another study that showed spending by elderly people diminishing (except health care) as they aged. As I recall, the amount of spending by age 85 was about half that of age 65. So the assumption that spending increases over time generally isn’t valid.

Anonymous | August 26, 2010 5:46 pm

The 4% is not a “rule”, but rather a loose guideline.
As a rule it is logically flawed because how do you decide which your starting point is ?

Drawing the obvious conclusion that every year is your starting year, therefore withdrawing 4% of your present capital may work, but only at the price of not having a steady income, which is the original objective.

Anonymous | August 26, 2010 5:19 pm

First of all, it’s only mildly interesting to a portfolio holder of today to look at 1926-1979 data. It may or may not be very relevant to an individual or family. My suggestion is to use a program that simulates what could happen per user inputs and assumptions. “Forecaster 3” is one good, free program that allows multiple inputs, assumptions including tax rates, inflation, age of death estimates [I use 90 for myself and 95 for my wife to be conservative], etc. Then it runs many hundreds [can be thousands if you choose] ‘Monte Carlo’ simulations to give one a range of possible outcomes. Even a great portfolio can go broke with a 2% drawdown rate per many negative outcomes. Conversely, a portfolio can grow like a weed if many things go right. Monte Carlo simulations yield a probable outcome plus the percentages for better or worse outcomes. Some financial house programs just give you an expected [average] outcome based on your inputs. With a good financial simulator, you can play what-if games and add or subtract risks per inputs and drawdown rates. As for a “magic drawdown percentage”, there is none. Age, expectations and risks taken and averted make a big difference. My guess is that for retirees, something around 0.3% per month will be safe {3.6%/year}, But, as the car dealer says, “Your mileage may vary”.

Anonymous | August 26, 2010 9:04 am

Anonymous | August 25, 2010 9:19 pm

When budgeting, it is easier to start with a small budget and then annually increase it, rather than start with a large budget and perhaps have to make drastic cutbacks somewhere down the road.

I may try to start with 3.0% (around age 67), then gradually bump it up to 4.0% over a period of four to ten years, then stay at 4.0% and try to roughly adjust for inflation, or at least some portion of inflation, each year. But once I get to 4.0%, if the investments ever have a very bad year, it might be necessary to do some belt tightening, and eliminate or cut back on the inflation adjustments for several years. As somebody else indicated, you might have to roll with the punches.

Anonymous | August 25, 2010 8:43 pm

To me, the “Optimal Spend” curve looks absurd. When retired, I want my income to be sufficient to provide for my basic living expenses, plus a reasonable amount for emergencies and for discretionary spending. If I need to withdraw 4.0% when I am around 86, how could I possibly expect to get by on 0.5% when I am 109?

I think that the 4.0% rule is a pretty good rule of thumb, but as another commenter pointed out, 3.5% is better, and 3.0% is even better, and so forth, in order to be more on the safe side. It is better to end up with too much rather than not enough, especially at a time when you are, as a practical matter, perhaps too old to be willing and able to work.

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Visit vanguard.com or contact your broker to obtain a Vanguard ETF or fund prospectus which contains investment objectives, risks, charges, expenses, and other information; read and consider carefully before investing.

Vanguard ETF Shares are not redeemable with the issuing Fund other than in very large aggregations worth millions of dollars. Instead, investors must buy and sell Vanguard ETF Shares in the secondary market and hold those shares in a brokerage account. In doing so, the investor may incur brokerage commissions and may pay more than net asset value when buying and receive less than net asset value when selling.

Investments in bond funds are subject to interest rate, credit, and inflation risk.

Diversification does not ensure a profit or protect against a loss in a declining market.